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March 20, 2013

IRAs and Taxes, Pt. 2: IRA Rollovers

As part of AdvisorOne’s Special Report, 20 Days of Tax Planning Advice for 2013, throughout the month of March, we are partnering with our Summit Business Media sister service,Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format. In this eighth article, we look at converting a retirement plan to a Roth IRA. In this fifth article, we look at converting a retirement plan to a Roth IRA.

Can an individual roll over or convert a traditional IRA or other eligible retirement plan into a Roth IRA?

Yes.

A “qualified rollover contribution” can be made from a traditional IRA or any eligible retirement plan to a Roth IRA. A rollover was not permitted prior to 2010 if a taxpayer had adjusted gross income (“AGI”) of more than $100,000 for the taxable year of the distribution to which the rollover related or if the taxpayer was a married individual filing a separate return.

Amounts that are held in a SEP or a SIMPLE IRA that have been held in the account for two or more years also may be converted to a Roth IRA.

The taxpayer must include in income the amount of the distribution from the traditional IRA or other eligible retirement plan that would be includable if the distribution were not rolled over. Thus, if only deductible contributions were made to an eligible retirement plan, the entire amount of the distribution would be includable in income in the year rolled over or converted. (Special rules apply for conversions made in 2010.) While the 10 percent early distribution penalty does not apply at the time of the conversion to a Roth IRA, it does apply to any converted amounts distributed during the five year period beginning with the year of the conversion.

Planning Point: Anybody could make a Roth IRA conversion for 2010. Income from a conversion in 2010 can be recognized one-half in 2011 and one-half in 2012, rather than all in 2010.

When an individual retirement annuity is converted to a Roth IRA, or when an individual retirement account that holds an annuity contract as an asset is converted to a Roth IRA, the amount that is deemed distributed is the fair market value of the annuity contract on the date of the (deemed) distribution. If, in converting to a Roth IRA, an IRA annuity contract is completely surrendered for its cash value, regulations provide that the cash received will be the conversion amount.

Non-rollover contributions made to a traditional IRA for a taxable year (and any earnings allocable thereto) may be transferred to a Roth IRA on or before the due date (excluding extensions of time) for filing the federal income tax return of the contributing individual and no such amount will be includable in income, providing no deduction was allowed with respect to such contributions. Such contributions would be subject to the maximum annual contribution limits.A “qualified rollover contribution” is any rollover contribution to a Roth IRA from a traditional IRA or other eligible retirement plan that meets the requirements of IRC Section 408(d)(3). A rollover or conversion of a traditional IRA to a Roth IRA does not count in applying the one IRA-to-IRA rollover in any twelve month period limit.

For years prior to 2010, the taxpayer’s AGI was calculated without regard to the exclusions for foreign earned income, qualified adoption expenses paid by the employer, and interest on qualified United States savings bonds used to pay higher education expenses. Deductible contributions to a traditional IRA also were not taken into account in determining AGI. Amounts included in gross income as a result of a rollover or conversion from a traditional IRA or other eligible retirement plan to a Roth IRA were not taken into account. Social Security benefits includable in gross income under IRC Section 86 and losses or gains on passive investments under IRC Section 469 were taken into account. The definition of AGI excludes minimum required distributions to IRA owners aged 70½ or older, solely for purposes of determining eligibility to convert a regular IRA to a Roth IRA.

An eligible retirement plan, for this purpose, includes a qualified retirement plan, an IRC Section 403(b) tax sheltered annuity, or an eligible IRC Section 457 governmental plan. Taxpayers, including plan beneficiaries, can directly transfer (and thereby convert) money from these plans into a Roth IRA without the need for a conduit traditional IRA. (Other than by direct conversion from an eligible non-IRA retirement plan, a beneficiary may not convert to a Roth IRA.)

Unless a taxpayer elects otherwise, income from conversions to Roth IRAs occurring in 2010 will be reported ratably in 2011 and 2012.

A rollover from a Roth IRA or a designated Roth account to a Roth IRA is not subject to the adjusted gross income limitation and is not subject to tax.

Planning Point: Major reasons for converting to a Roth IRA often include obtaining tax free qualified distributions from the Roth IRA and greater stretch from the Roth IRA because distributions from a Roth IRA are not required until after the death of the owner (or the death of the IRA owner’s spouse if the spouse is the sole designated beneficiary and elects to treat the IRA as the spouse’s own), rather than starting at age 70½. A conversion also may make sense if it is expected that tax rates will increase (from the time of conversion to the time of distribution), but not if tax rates will decrease. Consider whether any special tax benefits, such as net unrealized appreciation, would be lost if a qualified plan is converted to a Roth IRA. Also, a qualified plan may offer better asset protection than a Roth IRA. State laws vary on this issue. If a taxpayer cannot qualify under the Roth AGI limitations, perhaps he or she can establish a traditional IRA, and then convert that into a Roth IRA. Note that this, however, has not yet been addressed by the IRS.

Recharacterizations

If a taxpayer has rolled over funds from a traditional IRA or other eligible retirement plan to a Roth IRA during the taxable year, and later discovers that his or her AGI is in excess of $100,000 in a year before 2010 (or for any other reason wants the transaction undone), the taxpayer generally has until the due date for filing his or her return (including extensions) to correct such a conversion without penalty, to the extent all earnings and income allocable to the conversion are also transferred back to the original IRA, and no deduction had been allowed with respect to the original conversion.

This “recharacterization” in the form of a trustee-to-trustee transfer results in the recharacterized contribution being treated as a contribution made to the transferee IRA, instead of to the transferor IRA. A taxpayer can apply to the IRS for relief from the time limit for making a recharacterization.

For purposes of a recharacterized contribution, the net income attributable to a contribution made to an IRA is determined by allocating to the contribution a pro-rata portion of the earnings or losses accrued by the IRA during the period the IRA held the contribution. This allows the taxpayer to claim any net income that is a negative amount.

A time restriction is placed on reconversions (i.e., converting to a Roth IRA a second time after recharacterizing a first conversion). A person can reconvert back to a Roth IRA but only after the later of the beginning of the next year or thirty days after the recharacterization.

Planning Point: Where the value of converted property drops after a conversion to a Roth IRA, it may be useful to recharacterize the contribution back to the other type of IRA and then reconvert to a Roth IRA to reduce the amount taxable on converting to a Roth IRA. The time restriction on reconversions reduces, but does not eliminate, the potential value of this technique.

Reconversions and recharacterizations must be reported to IRS on Form 1099-R and Form 5498. Prior year recharacterizations must be reported under separate codes. All recharacterized contributions received by an IRA in the same year are permitted to be totaled and reported on a single Form 5498.

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